Arch Coal: Friend or "Arch" Enemy

Is Arch Coal (ACI) a friend or arch enemy? Given a very sharp correction in the price of coal stocks in general earlier this month, I wanted to know if the dip represented a buying opportunity for investors.

Despite my belief that the oil markets are bubbling over with froth, owning coal stocks may be an excellent way to hedge your bets if you will. If oil prices decline, coal usage can be expected to remain strong as demand for electricity increases.

More importantly clean burning technologies offer the potential to make coal an alternative energy solution further supporting demand. If oil prices rise the pressure will be on to increase coal usage.

Will that pressure result in a diamond for investors?

I think it will and I would be a buyer of ACI at these discounted prices. On a fundamental basis shares appear to be fairly cheap.

On a current basis, ACI trades for some 42 times trailing earnings. Huge revenue growth though drops the forward PE to 11 and close to single digits. The valuation is a classic case of superior growth at a huge discount.

The question for investors then must hinge on the revenue side of the equation. Will that growth continue?

Click here to find out what InvestorPlace Bloggers think about Arch Coal.

I think it will. Unlike gas, coal is mostly used for power generation. Demand for power is more stable than what we are likely to see in the fuel market. In addition, clean burning technology provides the potential to keep demand for coal at high levels.

In other words, the current state is likely to continue for some time. It is not a guarantee mind you, but I like the risk reward here. Where else in the market can you find superior growth at a cheap price?

OK, don't answer that question as there are more and more sectors that seem to be getting cheaper all the time. For me, I think coal is moving up the list of must haves in any long term portfolio.

I'm a bull on ACI. Where do bloggers stand?

The Bull Case - Russ of RD's Picks

Coal stocks, including Arch, have been strong over the course of this difficult market. A review of coal prices quickly explains why. According to a recent weekly NYMEX report issued by the Energy Information Administration, the near month price for Central Appalachian coal has climbed from a little over $44 per ton a year ago to over $138 per ton as of 27 June. In the same time frame, ACI stock has roughly doubled. At these coal prices, Santa may have to find something else for bad kids' stockings.

Last week, coal stocks got hit with a big correction on a drop in European coal prices. On 2 July, ACI dropped from just under $75 at the open to close a little above $62 per share. That was followed by an upgrade from Citigroup on the 3rd.

The key to Arch, and other coal companies, as investments going forward is whether the drop in European prices was a short-term market move or a signal of longer term pricing weakness.
ACI fundamentals still look strong. Despite a trailing PE of over 40, the stock sells for only 11 times 2009 estimates and those analyst estimates have been climbing steadily over the past few months.

The Energy Information Administration posts a lot of useful information on their coal data site. The latest International Energy Outlook 2008 Highlights predicts increasing coal demand going forward, largely due to projected increases in world electricity demand.

I don't think the drop in European prices marks the end of strong coal demand. World electricity demand is still growing and that means coal and natural gas demand will keep growing for the foreseeable future. Another potential source of coal demand is coal-to-liquid conversion for transportation fuels. I don't know what oil-to-coal price ratio makes that economically feasible, but if we get there coal companies would definitely benefit.

In addition to risk of a recession driving down coal demand, Arch faces cost risks. Mining is an energy intensive operation and those rising prices will hurt if they can't be passed on.
Rising labor costs also present a risk. If strength in the coal industry continues, labor is likely to push for pay increases to participate in the good times. If coal price hikes match or outpace costs, coal companies do well; if not, margins get squeezed.

Alternative energy presents a long-term risk to coal. If increases in wind, solar, and other renewable energy sources can grow faster than electricity demand, demand for coal would be reduced.

Energy stocks in general have been doing well in this tough market. Although there's no way to know for sure if that will continue, I don't see any reason for energy companies to start under performing. Given that strength, having some energy exposure in a portfolio makes a lot of sense, and Arch is a good way to get that exposure.

The Bear Case - Jim Van Meerten

Arch Coal (ACI) is a stock with a GREAT following, but is that a plus or a minus? At the present time institutional shareholders have tied up almost 98% of the stock. An individual investor should always look for a stock that has institutional following but I normally like to keep that at around 50%. When 98% of the stock is tied up by just a handful of institutions a few deciding to dump their stock could hurt you in the short run. Are you smarter than all the big boys?

Most of Arch's mines are in the US - that's a plus for stability of supply chain. Oil prices keep rising and coal is an energy alternative - that's another plus. Coal is a primary energy source for the metal refining industry - a third plus. India, China, US & Russia all will be long term consumers of coal.

Arch has been around for a while, has had stable earnings, margins and earning so the fundamentals look good. If coal prices go up faster than Arch's energy costs to get it out of the ground and to market everything will be fine. Arch is a stable, long term play but can you add it to your portfolio at the right price?

Arch has had a great run up. It's 5 year total return has been 564%. In 2006 you could have gotten in most of the year around 40 and the recent high has been up to over 77. If you are looking at Arch as a long term play I think you may have come to the dance too late, the big money seems to already have been made and all the big players got here way ahead of you.

Short term some of you traders might make a little money if you could put in some limit orders below 60 and make a few points on the up swing but don't expect this stock to double in the next year. Opportunity seems to be elsewhere.

To sum up, if you've got it congratulations you made a good decision but don't overstay your welcome, traders might make a few bucks if they time the price swing right but if you want to get in now and expect to double your money you have come to the dance too late.

I can appreciate Jim's take. It would certainly seem like it may be too late to dance with coal, but for the reasons mentioned above I think it is worthy of another look. Of particular note is the floor in demand for coal. With oil, demand destruction is a very real risk. I do not sense the same with coal.

At the end of the day I would use any selling as an opportunity to build a position in what is quickly becoming a staple of any long term portfolio.

Jamie Dlugosch
Executive Editor, InvestorPlaceBlogs

by The Freshman |  07/11/08  |  Stocks: ACI,